Friday, August 9, 2013

Pressure Is On Private Equity?

Carlyle Group LP's second-quarter results reaffirmed that it is a sellers' market for private-equity firms, as the firm reported it cashed out of investments at three times the rate at which it made new ones.

The firm announced results that fell short of analysts' expectations but said it had its best fundraising period since the financial crisis, raising nearly $7 billion.

The buoyant stock market that has lifted company values this year has been both boon and bane for buyout firms, which are reaping profits from past deals in huge volume this year but are finding it difficult to identify new deals where they can expect the 20% or better annualized returns such firms target.

"The overall investment environment has grown more challenging," said William Conway Jr., a Carlyle co-founder and co-chief executive. "With the world awash in liquidity, interest rates at rock bottom levels and asset prices being bid up, it has become increasingly difficult for us to compete when underwriting our investments, particularly in the U.S., to a 20% to 25% internal rate of return."

That is a contrast to last year when Carlyle was among the most active private-equity investors, conducting several multibillion-dollar buyouts.

During the second quarter, Carlyle collected $3.9 billion selling out of investments—primarily in real estate and stakes in companies it has already taken public—while investing $1.3 billion in new deals. That volume and ratio of sales to investments was roughly the same in the first quarter.

The sluggish buyout activity comes as Carlyle is as flush as ever. The firm raised $6.9 billion for its funds, marking its best fundraising period since the financial crisis, said David Rubenstein, also a co-founder and co-chief executive. Carlyle had $180.4 billion in assets under management at the end of June, including more than $20 billion ready to invest in its corporate buyout funds.

Although the asset sales overall generated profits and its latest buyout fund began paying fees during the second quarter, Carlyle's results fell below analysts' expectations.

Carlyle posted a $3.3 million loss, or 7 cents a share, up from a 26-cents-per-share loss the same period a year earlier, a quarter during which the Washington, D.C.-based firm was a public company for only part. The recent quarter's loss was attributable mostly to charges Carlyle took converting private partnership units into shares.

The firm reported economic net income of $156 million, up from a loss of $57.2 million a year earlier. Economic net income is a metric used to gauge publicly traded private-equity firms' performance and the value of their investments. It counts both realized and unrealized gains and also factors in accounting quirks that occur when partnerships transform themselves into public companies.

Performance fees, which represent the firm's slice of deal profits, were up from a loss last year that was related to unrealized losses. The value of its funds in which the firm and its shareholders collect a portion of the profits rose 3% during the second quarter, down from 7% growth reported in the first quarter.

Distributable earnings, the portion of profits from which shareholder payouts come, were $163 million, 41% higher than a year earlier. The firm said it would pay a dividend of 16 cents a share for the quarter.

Distributable earnings, which include cash profits that flow back to investors and which Carlyle executives say are the best measure of the firm's performance, benefited from gains made selling big blocks of stock in companies, including oil explorer Cobalt International Energy Inc., television-ratings business Nielsen Holdings NV and car-rental business Hertz Global Holdings Inc. Carlyle executives said those and other so-called block sales generated between two and five times the firm's original investments in the companies.

Carlyle shares were down in Wednesday afternoon trading. The stock, which is up about 6.6% on the year, hasn't fared nearly as well as that of rival firms Apollo Global Management LLC, KKR & Co. and Blackstone Group LP, which are each up more than 30% on the year.

Carlyle's shares have underperformed peers' in part because Calpers, the California public pension fund, in early June liquidated its stake in the firm, boosting the number of shares that are publicly traded by more than 20%, depressing the price.

Earlier this week, I discussed why smart money is getting out and looked at the implications for the overall market and whether we've reached a top. Buyout firms are taking advantage of hot credit and equity markets to realize on their investments and lock in gains. This is good news for them and their investors.

The bad news is that top buyout funds like Carlyle are now flush with cash and the overall investment environment is extremely challenging, especially in the United States. William Conway summed it up well: "With the world awash in liquidity, interest rates at rock bottom levels and asset prices being bid up, it has become increasingly difficult for us to compete when underwriting our investments, particularly in the U.S., to a 20% to 25% internal rate of return."

Of course, all investors are grappling with these issues but for private equity, it's particularly hard. Their average holding period is six years and they typically buy unloved or underperforming companies, fix them, cut costs, and then take them public in a few years, often after loading them up with debt and extracting huge special dividends.

There’s a big bottleneck of companies PE firms bought before the financial crisis, and as the median holding period approaches six years, investors are getting antsy to cash out. According to Mergermarket.com, while the number of new buyouts has dropped dramatically, the pace of exits has accelerated: $68.6 billion in the second quarter, double the dollar volume of the first quarter.

Private equity fundraising was very strong in Q2 2013, with the highest quarterly value raised since the onset of the financial crisis in late 2008. The fact that the average size of private equity funds closed in Q2 2013 was $800mn and experienced managers dominated the fundraising environment, shows that investors are increasingly looking to back fund managers with a demonstrable track record.

Buyout firms have a record level of expiring funds this year, raising the prospect that many will have to ask investors for more time to do deals or not use the money at all.

Advisory firm Triago says that $145 billion of so-called dry powder - money pledged by investors, typically for set periods of time - is due to be spent in 2013. Triago estimates that 10 percent of the $145 billion will remain uninvested.

Unless the fledgeling recovery in the market for new deals gathers pace, investors could end up having paid management fees on ringfenced capital that sat idle and for which they received no return.

The damage this can do to a private equity firm's reputation, and its ability to raise future funds from investors, increases the pressure to put the money to work.

However, the first half of this year does not bode very well for the second. The first-half total for deals across all stages of the private equity funding cycle was down slightly on the previous six months, at $148.6 billion, data firm Preqin says.

The total volumes of dry powder also suggest that deals are hard to come by. Preqin data shows that these uninvested funds are on the rise again after falling steadily since the end of the financial crisis. The total volume in May was $366 billion, up from $355 billion in December.

"There are not many buyouts happening because prices are still pretty high and there is not much debt about from the banks - and what debt there is is very expensive," Tim Syder, of British private equity firm Electra, said.

While total global deal flow is up $40 billion on the same time last year, the Preqin data shows, it was two big deals - the $28 billion takeover of H.J. Heinz and the $24.4 billion bid for Dell - that stopped volumes sliding to their lowest six-month level since 2010.

In the United States those two deals helped to lift volumes by two thirds. In Europe they were up by 30 percent.

BOOM-TIME BUYOUTS

Deal volumes are also being curbed by cash-rich corporations being able to resist pressure to offload businesses, as well as private equity holding off selling assets that have yet to reach a level at which they can be sold profitably.

"We have had the same amount of capital chasing a third or a quarter of the number of deals," Syder said.

Much of the focus this year has been the recovery in exits for buyout firms. The second quarter, at $93 billion, was the second strongest quarter since 2006, Preqin data shows.

Close to $42 billion has also been raised by private equity firms opting to list businesses on stock exchanges this year as investor appetite for initial public offerings (IPOs) improved.

But private equity has yet to test the strength of the IPO recovery for their big boom-time buyouts, such as Merlin Entertainments and Toys R Us, which are still on their books and tying up investor money.

Management consultancy Bain & Company estimates the total amount of money investors have tied up in private equity - both committed capital and invested funds - is now approaching $3 trillion.

"That number is huge. It is as big as has ever been the case in private equity," said Graham Elton, the head of Bain's Europe, Middle East and Africa private equity practice.

INVESTOR FRUSTRATION

Most investors are expected to agree to extend their investment periods, particularly as many of the funds raised before 2008 suffered an 18-month hiatus when dealmaking collapsed during the financial crisis.

Investors generally see such extensions as preferable to the alternative.

"There's always a worry ... that, as the end of the investment period draws near, money will be 'spent' rather than invested," said Charles Magnay, partner at Altius Associates, which manages and advises on private equity investments.

However, Triago's estimate for 10 percent of the expiring dry powder remaining uninvested this year is double the historical average.

On top of this, the few firms still able to raise big new funds in the hunt for new fees are now wary of taking on more money than they can later invest.

On Monday CVC Capital Partners said it had raised a 10.5 billion euro ($13.9 billion) buyout fund. A source familiar with the matter said that it had attracted commitments for more than that and had to turn away money.

With few deals to go round and firms under pressure to spend, particularly if investor frustration has been heightened by poor performance from other investments in the fund, there remains a risk of overpaying for less attractive assets.

As Simon Borrows, chief executive of British private equity group 3i, said: "Do the people that raise all the money then remain disciplined and spend it wisely, rather than rush to get the money out of the door?"

In Triago’s conversations with GPs, they cite the uncertain global economic outlook as a key reason they are not willing to pony up the large sums sellers often want. Normally positive conditions for purchases - factors that are helping PE exits - are also contributing to broken negotiations, with owners opting for cheap financing over sales, or selling via attractively priced IPOs. Declining PE purchases in recent quarters also mean rising estimates concerning the amount of commitments likely to reach term without being invested. Triago believes some $20 billion may expire this year without being invested, adding significantly to investor cash.

The pressure is on private equity. They can sit on uninvested capital for only so long before investors start losing patience. But investors do not want them to spend the money on pricey deals. While opportunities in the U.S. are harder to find, PE giants are increasingly focusing their attention on Asia and other regions.

Still, many of the challenges in private equity noted by Altius Associates at the start of year persist. Cashing out is the easy part. The hard part for PE firms will be putting new money at work in an increasingly challenging investment environment. Their investors will be watching them closely.

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I am an independent senior economist and pension and investment analyst with years of experience working on the buy and sell-side. I have researched and invested in traditional and alternative asset classes at two of the largest public pension funds in Canada, the Caisse de dépôt et placement du Québec (Caisse) and the Public Sector Pension Investment Board (PSP Investments). I've also consulted the Treasury Board Secretariat of Canada on the governance of the Federal Public Service Pension Plan (2007) and been invited to speak at the Standing Committee on Finance (2009) and the Senate Standing Committee on Banking, Commerce and Trade (2010) to discuss Canada's pension system. You can follow my blog posts on your Bloomberg terminal and track me on Twitter (@PensionPulse) where I post many links to pension and investment articles as well as my market thoughts and other articles of interest.

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